Role of Money

Money serves three important purposes in an economy. (a) Medium of exchange (b) Unit of account ( c ) Store of value Demand for money arises as it performs one of the functions. Classical economists give high priority to medium of exchange

 Money acts as a medium of exchange. The double coincidence of wants, which is required for barter, is unnecessary when a medium of exchange is used. Money is a store of value for an individual but not for society as a whole. Bank deposits (particularly the demand deposits) are now the biggest part of the total amount of money in the economy, so the behaviour of the banking system is central to determining the total amount of money supply.

 What are the implications of E money for the monetary system? Central bank and banking system determine the supply of money in economic system. Banks create money in the process of lending or credit creation.

What is money?
Money is anything that serves as a commonly accepted medium of exchangeComponents of money supply M1 = Paper currency+ coins (with public) + demand deposits M2= M1+saving deposits with post offices M3= M1+net time deposits with banks M4= M2+total deposits with post offices (excluding NSCs)

 M1= Most liquid measure of money M4= Least liquid measure of money Types of money(1) Commodity Money (2) Representative Money (3) Fiat Money (4) Commercial Bank Money

Credit creation by Banks

Banks are manufacturers of money. Banks receives deposits Banks through multiplier of loans and advances can multiply its deposits. This process is called multiple expansion of bank deposits.

 Deposit Multiplier=

1 x 2000 rr Where Rs. 2000=Initial deposit rr = Reserve rates= 20% of deposits = 1 x 2000= Rs. 10000 0.2 Although banks create money, they do not create wealth. Wealth is created by entrepreneurs / firms who borrow money from banks.

Equilibrium in money market

Classical economists E= Demand for loanable funds= supply of loanable funds. It is the flexiblity of interest rate which brings about equilibrium in money market. The demand for money was determined by the quantity theory of money i.e MV= PY V= PY M

Where: M= Money supply V= Velocity of money P= Price level Y= Output level Rates of nominal GDP to the stock of money.

Quantity theory of money

If quantity of money increases it will cause a proportionate increase in the price level of output. Fishers equation MV= PY Or P= MV Y M= Quantity of money V= Velocity of money (assumed to be constant) Y= GNP or aggregate output ( remain constant at full employment level) Free market economy is always moving towards full employment in long-run.

 Sum up: Increase in money supply leads to increase in money wages and prices, leaving real wages, employment and output unaffected. Changes in money supply leaves interest rate unaffected.

Quantity Theory of Money (Revision) The quantity theory of money states that there is direct relationship between the quantity of money in an economy & level of price of goods & services sold. According to Quantity Theory of Money if the amount of money in economy doubles, the price level also doubles, causing inflation.

 Quantity theory of money is based on The Equation of Exchange i.e Amount of Money x Velocity of Money= Total Expenditure

 Interest rate depends on productivity of capital ( real resource as against monetary illusion)

Limitations of classical view on role of money

1. It does not explain how a change in money would lead to change in prices 2. Prices are regarded as a passive factor which is unrealistic. Not only M determines P but also P determines M

Keynes liquidity preference theory of interest

People prefer to hold their resources in the form of ready money ( liquid money or cash) for the following motives. 1. Transaction motive 2. Precautionary motive 3. Speculative motive

 Transaction motive: To bridge the interval between the receipt of income and its expenditure. Demand for the money is a demand for real cash balances because people hold money for buying goods and services.

 According to keynes, demand for money for transaction purposes depends on real income and is not influenced by interest rate. However, latest research shows that holding of cash balances for transaction purposes also depends upon interest rate because of opportunity cost principle.

 Precautionary motive for holding money depends on psychology of individual. Speculative demand for money: cash held under this motive is used to make speculative gains by dealing in bonds or other assets whose prices fluctuate. If bond prices are expected to fall, businessman will buy bonds to sell when their prices actually rise.

 Keynes recognized three types of demand for money (a) Transaction demand (b) Precautionary demand ( c ) Speculative demand

Keynesian Version
Demand for money for precautionary and transaction demand for money may be fixed proportion of income. The speculative demand for money is inversely related to interest rate.

 When interest rate is high, people keep a lower amount in the form of cash, as they would be losing out interest there of. When interest rate is very low, people would prefer to keep their money with themselves in cash instead of financial assets.

Definition and Determinants of interest:

Payment to those who supply financial capital for investment in real capital assets is called market rate of interest. Interest is the price paid for use of loanable funds. Interest is paid because capital is scarce and productive.

Elements of gross interest (a) Payment for risk (b) Payment for inconvenience ( c ) Payment for management of loan (d) Payment for exclusive use of money ( pure interest)

 Summing up: Demand for money will be an increasing function of transactions and decreasing function of interest rate. The former can be taken to be proportional to real output (O) or Income (Y). People are interested not in the nominal value of their money but in purchasing power of their money. The demand for money is, therefore, demand for real balances i.e money stock deflated by aggregate price level.

Liquidity trap
Perfectly elastic portion of liquidity preference curve indicates the position of absolute liquidity preference of the people. It is called liquidity trap because expansion of money supply gets trapped in the sphere of liquidity trap and therefore can not affect the rate of interest, therefore investment. In this situation, monetary policy becomes ineffective.

 Liquidity trap (Continued) The curve representing speculative demand for money becomes infinitely elastic when rate of interest is low. The segment from B to C is called liquidity trap because people prefer liquidity to keeping their money in financial assets.

 Summing up: Demand for money=M1 + M2 M1= Precautionary motive+ Transaction motive(Interest inelastic). M2= Speculative motive highly interest elastic According to Keynes: interest is the reward for parting with liquidity for a specified period.

Critical appraisal of Keynesian theory of Liquidity Preference

Keynes ignored the role of real factors like productivity of capital and thriftiness in determining interest rate. Keynes ignored the role of availability of savings on interest rate. If MPC goes up, MPS would go down which would lead to rise in interest rate. Keynesian theory of interest rate is indeterminate . At different levels of income, there will be different equilibrium rates of interest. Thus we can not know the rate interest unless we know liquidity preference curve and also we can not know LPC unless we know the level of income. However, we can not know the level of income unless we know the rate of interest. In other words, Keynesian theory of interest rates suffer from circular reasoning

 Keynes analysis helps us to obtain a LM curve showing what will be rate of interest at different levels of income and not any unique or particular rate of interest.

 As income increases, money demand curve shifts outward and therefore the rate of interest which equals supply of money with demand for money rises.

 Monetarism: Friedmans modern quantity theory of money Original theory: Increases in money supply would bring about an equal % rise in general price level. Post Keynesian theory: (a) People desire to hold a constant fraction of income in the form of money or cash balances. (b) Desired holding of money or cash balances is the function of nominal income i.e GNP. Greater the GNP at a given price, greater would be the cash balances which people wish to hold.

 (c)Friedman distinguishes between the amount of nominal money holdings and real cash balances. (d) Real money holding represents the purchasing power of money held= M P (e)Friedman focuses on desire of people to hold a fraction of their income in terms of real cash balances.

 Limitations of Keynesian liquidity preference theory. Keynesian views that demand for money for transaction and precautionary motives is interest inelastic is not acceptable to many economists. Prof. Tobin argued that when interest rate is very high, even in the short run, the demand for money (L1) for these motive starts responding to changes in interest rates. Demand for money for speculative purposes, according to Keynes, depend on future interest rates. According to Tobin, optimum amount of monetary assets ( currency+ demand deposit) and non monetary assets ( stock and bonds) will depend on Interest foregone on cash balance held and cost of acquiring bonds i.e brokerage.

 Md= kPY Md = demand for money K= Proportion of national income which people want to hold in the form of money holdings PY= National income obtained by multiplying the price level (P) with the real income (Y) Monetarists believe that besides nominal income, the demand for money depends upon

Real rate of interest Inflationary expectations

Frequency of payments

 Higher the nominal rate of interest, lower will be the desire to hold money Higher the inflationary expectations, people would like to spend more money now and hold less cash and prefer real assets Income velocity of money varies directly with the frequency of payments. With increase in frequency of payments, the velocity of money would rise Given the rate of interest, frequency of payments and inflationary expectations, the people and firms would hold a certain proportion of national income in cash balances.

 Equilibrium Md= Ms When Ms> kPY i.e when money supply exceeds demand for money, reaction of people will be to spend the excess money on goods and services and vice-versa. Spending of excess money would lead to increase in aggregate demand, and if the economy is in full employment equilibrium, it would lead to increase in prices.